I was downstairs in the greenroom, waiting for you to appear. I said hello to your family. I said hello to your friends. I said hello to this situation that never yields. So begins the song Yield, written by Amy Ray and from the American folk-rock duo, the Indigo Girls. The song was released on their 2002 album Become You.
This month we are taking the Guerrilla Economics Blog back to its roots. When I first started posting these missives, I wanted to inform people about some of the economic statistics and lingo that was being presented in the MSM and on business television. More often than not, economic statistics and principles are misrepresented in the press, ensuring that most people have a misunderstanding of them.
Today we are going to look at the concept of the inverted yield curve. Ever since the interest yields on short term treasury securities (those with terms of less than 2 years) rose above that of the 2 year note we have been hearing about the power of this situation to not only forecast recession but maybe even cause one.
This idea comes about because every US recession for the past 60 years was preceded by an inverted yield curve. Of course, depending on the time frame examined, every recovery was also preceded by an inverted yield curve, as was every war, every moon landing and every triple crown winner. The fact is recessions have tended to closely follow a negative spread between short- and long-term interest rates, but in other cases they have not. And this is over a very short time period, so statistically speaking this is not a robust indicator in and of itself.
Some have suggested that lenders are forecasting a weaker economy in the future and therefore, will offer loans at lower rates. This is why some suggest that the statistic is a good sign of recession. However, this explanation does not make a lot of sense. Recessions are generally short-term events, so if one were about to occur it would be over long before 10-year or 30-year notes are due. In addition, short-term interest rates are manipulated by central banks so the market does not truly set yields to the left of the curve.
Others see an inverted yield curve as an indication that investors have little confidence in the near-term economy and perceive near-term investments as riskier than the out years. As a result, they tend to buy stable longer-term investments even though they may receive lower yields and shun bonds with maturities of 5 years of less.
So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yields on those bonds fall. They are in demand, so they don’t need as high of a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors. Eventually, the yield on short-term Treasuries become higher than the yield on long-term bonds and the yield curve inverts.
The same considerations will impact the private debt markets with businesses and consumers spending more to service shorter term debt, and reducing investments in the future.
This all makes sense, particularly if one believes that markets are the best predictors of the future. However, let’s say hello to this situation that never yields. History never exactly repeats itself, and in this case, the inversion of the yield curve may be due to completely different reasons.
Let’s look first at the 10-year yield. Following the 2007-2008 recession yields on 10-year Treasury’s have plodded along at about 2.5 percent. They have gone up a little, and down a little but they have basically been stuck at 2.5 percent. Even with the government debt soaring, and the Federal Reserve dumping debt on the market, yields on the 10-year note have been pretty flat.
On the other hand, short term debt yields (as measured by say the 2-year note) have creeped up steadily since the middle of 2015. One would expect to see this as the economy recovers, and dutifully, the Federal Reserve has been raising its benchmark Federal Funds Rate in line with the market. The 2-year yield began to fall in October of last year and is now down 60 basis points since its peak.
So the yield curve flattened not because of high demand for short-term debt but rather tepid demand for long-term debt for a very long time. Basic economics tells us that long-term rates should reflect short-term rates plus a factor for risk, with that risk being inflation. When inflation levels begin to rise, investors sell off longer term debt causing yields to rise. Amazingly, inflation never reared up during the last business cycle, and long-term rates remained flat.
With investors continuing to believe that inflation will remain in-check, we should expect to see short- and long-term interest rates converge, exactly what is happening. So rather than a traditional inverted yield curve, current rates are suggesting more of a flat yield curve, with the level of risk pretty constant across time. This is in fact, more of a goldilocks situation than a sign of an imminent bear at the door.
This does not mean that a recession is not near, but rather that the flattening yield curve may not be the best forecasting tool to use. So while all of the pundits are downstairs in the greenroom, waiting for recession to appear, keep in mind that they are predicting this based on an indicator that is pointing exactly the opposite way.